[Book Summary] Core Asset Classes: A Fundamental Approach to Personal Investment by David Swensen

Core Asset Classes

Defining asset classes combines art and science in an attempt to group like with like, seeking as an end result a relatively homogeneous collection of investment opportunities.

The author discusses the characteristics of core asset classes:

• Contribute basic, valuable, and differentiable characteristics to a portfolio
• Rely on market-generated returns rather than active management
• Derive from broad, deep, and investable markets

However, the definition is not precise. I would classify core asset classes into bond, equity, and a combination of the two, like real estate.

TL;DR

Domestic Equity

1. Importance of Domestic Equity:
   • U.S. stocks form the core of most institutional and individual investment portfolios.
   • They offer substantial long-term growth potential, matching the needs of investors seeking portfolio growth over many years.
   • Historical data is impressive: Jeremy Siegel's 200-year data shows U.S. stocks earning 8.3% per annum, while Roger Ibbotson's 78-year data indicates 10.4% per annum.
   • No other asset class has such a strong long-term performance record.
2. Equity Risk Premium:
   • Defined as the additional return investors receive for accepting higher risk compared to bond investments.
   • Historical data suggests a significant premium: Ibbotson's data shows a 5.0% per annum differential over 78 years, while Siegel's 200-year data indicates 3.4% per annum.
   • The article cautions against blindly relying on past performance, citing work by Jorion and Goetzmann on survivorship bias.
   • The U.S. market's exceptional performance (4.3% real annual appreciation from 1921-1996) may not be representative of global markets (median 0.8% for other countries).
3. Components of Stock Returns:
   • Robert Arnott's study breaks down 200-year returns: 5.0% from dividends, 1.4% from inflation, 0.8% from real dividend growth, and 0.6% from rising valuations.
   • The study challenges conventional wisdom about stock returns being primarily driven by growth.
   • Arnott argues that due to low current dividend yields and limited prospects for dividend growth or valuation increases, future equity returns and risk premiums are likely to be significantly lower than historical averages.
4. Inflation Protection:
   • Stocks generally provide long-term protection against inflation, based on James Tobin's q ratio theory. The q ratio is defined as the ratio of the market value of a company's assets (as measured by the market value of its outstanding stock and debt) to the replacement cost of the company's assets. If q < 1 (Inflation does not result in higher equity prices): The replacement cost exceeds the market value. This implies it's more economical to buy companies on the stock exchange rather than create new companies.
   • However, this relationship can be unreliable in the short term, as evidenced by the stock market's poor performance during the high inflation of the 1970s.
5. Alignment of Interests:
   • There's often alignment between corporate managers and shareholders, as both benefit from increased corporate profitability.
   • However, agency problems can arise due to the separation of ownership and control in public companies.
   • The article discusses issues like excessive executive compensation, corporate perks, and questionable corporate philanthropy.
6. Stock Options:
   • Can create misalignment between management and shareholder interests, especially when share prices decline.
   • Some companies, like Microsoft, are moving away from options to restricted stock awards to better align interests.
7. Market Characteristics:
   • As of December 31, 2003, the U.S. stock market was valued at over $13.1 trillion with 5,244 securities (Wilshire 5000).
   • The market can be categorized by size (small, medium, large cap), character (growth/value), and industry sector.
   • Aggregate market statistics: 1.5% dividend yield, 25.5 price-earnings ratio, and 3.1 price-book ratio.
8. Cautions and Recommendations:
   • While equities are attractive for long-term investors, the article warns against over-reliance on stocks.
   • Historical performance may overstate the attractiveness of U.S. stocks.
   • Bonds and cash may outperform stocks for extended periods (e.g., it took 21 years after the 1929 crash for stocks to match bond returns).
   • The article recommends diversification and owning a market-like portfolio of equities within a broader, well-diversified investment strategy.

U.S. Treasury Bonds

1. U.S. Treasury Bonds:
   • Represent a portion of the U.S. government's public debt
   • Enjoy full-faith-and-credit backing of the U.S. government, meaning no risk of default
   • Prices fluctuate inversely with interest rates
   • Provide unique diversification in investment portfolios, especially during financial crises
   • Generally have lower expected returns compared to equity investments
   • Interest rate risk depends on the investor's time horizon. An investor with a six-month time horizon finds six-month Treasury bills riskless. Unless investors match the holding period with maturity, price and rate changes may cause portfolio values to diverge from expected levels.
   • Pure Treasury bonds are preferable to Government-Sponsored Enterprise (GSE) debt
2. Bond Pricing and Inflation:
   • Traditional Treasury bonds deal with nominal returns
   • Inflation can affect the real (after-inflation) returns of bonds
   • Unanticipated inflation erodes purchasing power of fixed payments
   • Bonds behave differently from equity when inflation deviates from expectations, which provides the greatest diversification. Unanticipated inflation crushed bonds while ultimately benefiting equities. Unanticipated deflation boots bonds while undermining stocks.
3. Alignment of Interests:
   • Treasury bond investors' interests are generally well-aligned with the U.S. government
   • The government is perceived as a neutral player in debt management
4. Market Characteristics:
   • As of December 31, 2003, U.S. government bonds totaled $2.8 trillion
   • Treasury bonds trade in the deepest, most efficient market globally

Inflation-Linked Bonds

1. Treasury Inflation-Protected Securities (TIPS):
   • Introduced in 1997
   • Protect investors from inflation by adjusting principal for inflation. TIPS protect investors from inflation by adjusting the principal amount based on the Consumer Price Index, applying a fixed interest rate to this adjusted principal, and guaranteeing at least the original face value at maturity.
   • Provide a riskless instrument for generating certain real returns
   • Should be considered a separate asset class from regular Treasury bonds because they respond oppositely to unanticipated inflation and deflation, providing real rather than nominal returns and offering distinct diversification benefits in a portfolio.
   • Perfectly hedge against inflation due to their payment mechanism
2. Foreign Government Inflation-Protected Securities:
   • Issued by countries like the UK, Canada, Australia, France, and Sweden
   • Not useful for U.S. investors as a hedge against U.S. inflation due to currency risk
3. Corporate Inflation-Protected Securities:
   • Suffer from credit risk, illiquidity, and unattractive call provisions
   • May be less reliable in high-inflation environments

Foreign Developed Equity

1. Foreign Developed Equity:
   • Expected to provide similar long-term returns to U.S. equity investments
   • Two critical differentiating characteristics: a) Different response to economic forces, causing varied returns across regions b) Exposure to foreign currency fluctuations
   • Historical performance: From 1970 to 2004, MSCI EAFE Index returned 10.0% per annum vs. 11.3% for S&P 500
   • Provides valuable diversification opportunities for investors
   • Debate over increasing correlation between global markets due to economic integration
   • Example of Japan's market performance in the 1980s vs. 1990s illustrates how individual markets can behave differently
   • Investors tend to chase performance, often increasing foreign allocations after strong returns and decreasing after poor performance
   • Recommends maintaining a disciplined diversification policy regardless of short-term market movements
   • Foreign currency exposure adds to portfolio diversification, but should not exceed roughly 25% of portfolio assets
2. Market Characteristics and Comparisons:
   • As of December 31, 2003: a) Developed foreign markets totaled $13.9 trillion (MSCI data) b) U.S. market capitalization was $13.1 trillion
   • Japan led non-U.S. developed markets with $3.2 trillion, followed by UK ($2.4 trillion), France ($1.4 trillion), and Germany ($1.1 trillion)
   • Regional breakdown: Europe 62%, Asia 27%, Canada 6%, Australia/New Zealand 4%
   • Foreign developed markets had a dividend yield of 2.4%, P/E ratio of 23.5, and price-book ratio of 2.0
   • Regional variations: Europe yielded 2.8% vs. Japan's 1.0%; Europe P/E ratio 20.3 vs. Japan's 66.0
3. Investment Philosophy and Strategy:
   • Emphasizes the importance of diversification across asset classes and geographic regions
   • Warns against performance chasing and advocates for a disciplined approach to maintaining diversified portfolios
   • Suggests that foreign equity exposure can reduce overall portfolio risk when managed properly
   • Highlights the challenges of currency hedging in foreign equity investments
   • Notes that alignment of interests between investors and corporations may vary across countries and cultures

Emerging Markets Equity

Emerging Markets Equity:

1. Definition and Risk Profile:
   • Emerging markets are defined as countries with economies in an intermediate stage of development, neither undeveloped nor fully developed.
   • Investing in emerging markets represents a high-risk, high-expected-return segment of the marketable equities universe.
2. Historical Perspective:
   • The text references a study by Brown, Goetzmann, and Ross titled "Survival," which examined 36 stock exchanges operating at the beginning of the 20th century.
   • More than half of these exchanges experienced major trading interruptions, often due to nationalizations or war.
   • Surprisingly, 15 of the 36 markets from 1900 were still classified as emerging markets over 100 years later.
   • One market (Belgrade, Serbia) no longer even qualifies as an emerging market in the 21st century.
3. Market Evolution:
   • Morgan Stanley Capital International (MSCI) began tracking emerging markets in 1988 with an index of 8 countries.
   • By 1993, this expanded to 19 countries, including additions like India, Korea, and Portugal.
   • In 1998, the total reached 28 countries, incorporating South Africa, Russia, and several Central European nations.
   • Some countries have graduated from emerging to developed status (e.g., Portugal in 1997, Greece in 2001).
4. Economic Growth vs. Market Performance:
   • The text cautions against confusing strong economic growth with strong equity market prospects.
   • It provides examples of how economic growth might occur without benefiting equity investors: a) In command economies without securities markets b) In market-oriented economies with poor resource allocation c) In cases where corporate revenues disproportionately benefit management or government, rather than shareholders
   • China's state-owned enterprises are cited as an example of inefficient allocation.
5. Market Infrastructure and Investor Protections:
   • Development of market infrastructure in emerging economies is described as proceeding "in fits and starts."
   • Quality of securities legislation, enforcement of regulations, and management's fidelity to shareholder interests vary widely.
   • The text warns that most emerging markets can be quite inhospitable compared to the protections investors are accustomed to in the United States.
6. Government Interference:
   • The text highlights how government policies can dramatically interfere with investor interests.
   • It cites the example of Malaysia restricting the convertibility of its currency (ringgit) during the 1998 Asian crisis, effectively trapping foreign investments.
7. Corporate Governance Issues:
   • The text likens corporate actions in emerging markets to the "Wild West."
   • It humorously references advice to invest in Russian enterprises where management attempts "grand theft" rather than "petty larceny," implying that management seeing value in their enterprises might attempt to steal the entire entity.
8. Alignment of Interests:
   • Inferior alignment of interests is identified as a critical risk factor in emerging markets.
   • This misalignment stems from less-evolved legal and regulatory frameworks.
   • Issues include government controls on ownership and voting rights, potential capital controls, and family-controlled companies acting against minority shareholder interests.
   • Lack of transparency is noted as compounding these problems.
9. Market Characteristics (as of December 31, 2003):
   • Total market capitalization: $2.8 trillion
   • Largest markets: Taiwan ($364 billion) and Korea ($294 billion)
   • Smallest markets: Venezuela ($4 billion) and Sri Lanka ($3 billion)
   • Regional breakdown: Asia (54%), Latin America (19%), Africa and Middle East (18%), Europe (9%)
   • Valuations: Emerging markets had better dividend yields (2.3%) compared to the U.S. (1.5%)

Real Estate

1. Nature of Real Estate Investments:
   • Real estate investments typically involve commercial properties like office buildings, apartment complexes, industrial warehouses, and retail establishments.
   • High-quality real estate generates significant cash flow from long-term lease arrangements.
   • Real estate combines characteristics of both fixed income and equity investments.
2. Risk and Return Profile:
   • Returns and risks fall between those of bonds and equities.
   • Historical data suggests real estate returns are about 2.5% per annum above bonds.
   • From 1978 to 2003, marketable real estate securities returned 12.0% annually, compared to 13.5% for S&P 500 and 8.7% for intermediate-term U.S. Treasury bonds.
3. Valuation Considerations:
   • Replacement cost is a key determinant of market value (Tobin's "q" ratio).
   • Real estate valuation is often more straightforward than other risky assets due to the observable nature of replacement costs.
4. Public vs. Private Holdings:
   • Real estate investments are available in both publicly traded and privately held forms.
   • Real Estate Investment Trusts (REITs) offer tax advantages and exist in both public and private forms.
   • Public market securities often trade at prices that deviate from fair value, leading to opportunities and risks.
5. Performance Comparison:
   • From 1978 to 2003, public REITs (NAREIT All REIT Index) returned 12.0% annually.
   • Private real estate (NCREIF National Property Index) returned 9.3% annually over the same period.
6. Investment Vehicles for Individual Investors:
   • Publicly traded REITs generally offer low-cost exposure to high-quality real estate portfolios.
   • Many privately offered retail real estate partnerships have excessively high costs, hindering investor returns.
7. Case Studies: a. Wells Private REIT:b. TIAA Private Real Estate Account:c. Publicly Traded REITs:
   • Demonstrates excessive fees and conflicts of interest.
   • Up to 16% of investor capital consumed by fees before property investment.
   • Additional ongoing fees for management and transactions.
• Offers superior diversification, greater liquidity, and far lower fees compared to Wells.
• No up-front fees, lower ongoing fees, and fewer conflicts of interest.
• Generally offer greater transparency and liquidity than private offerings.
• Vanguard REIT Index Fund highlighted as a low-cost, high-quality option (0.27% annual fee).
• Contrasted with Wells S&P REIT Index Fund, which has much higher fees (up to 2.17% annually plus sales charges).
8. Inflation Hedge:
   • Real estate often correlates strongly with inflation due to the relationship between replacement cost and market value.
   • The nature of lease structures can influence the rate at which property values respond to inflationary pressures.
9. Market Characteristics (as of December 31, 2003):
   • Public REITs: $230.2 billion market, 5.7% dividend yield, trading at 17.5% premium to fair value.
   • Private real estate (NCREIF Index): $132.4 billion in assets, 8.0% dividend yield.
10. Summary:
    • Real estate falls between equity and debt in terms of risk and return.
    • Provides inflation sensitivity and portfolio diversification.
    • Investors should carefully consider fee structures when choosing between public and private real estate investments.
    • Passively managed, publicly traded REIT funds often offer the most cost-effective exposure for individual investors.